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Skip all front matter: Jump to Page 16 e RAND Corporation is a nonprot institution that helps improve policy and decisionmaking through research and analysis. is electronic document was made available from www.rand.org as a public service of the RAND Corporation. CHILDREN AND FAMILIES EDUCATION AND THE ARTS ENERGY AND ENVIRONMENT HEALTH AND HEALTH CARE INFRASTRUCTURE AND TRANSPORTATION INTERNATIONAL AFFAIRS LAW AND BUSINESS NATIONAL SECURITY POPULATION AND AGING PUBLIC SAFETY SCIENCE AND TECHNOLOGY TERRORISM AND HOMELAND SECURITY is product is part of the RAND Corporation monograph series. RAND monographs present major research ndings that address the challenges facing the public and private sectors. All RAND mono- graphs undergo rigorous peer review to ensure high standards for research quality and objectivity. Lloyd Dixon, Noreen Clancy, Krishna B. Kumar Hedge Funds and Systemic Risk C O R P O R A T I O N The RAND Corporation is a nonprofit institution that helps improve policy and decisionmaking through research and analysis. RAND’s publications do not necessarily reflect the opinions of its research clients and sponsors. R ® is a registered trademark. © Copyright 2012 RAND Corporation Permission is given to duplicate this document for personal use only, as long as it is unaltered and complete. Copies may not be duplicated for commercial purposes. Unauthorized posting of RAND documents to a non-RAND website is prohibited. RAND documents are protected under copyright law. For information on reprint and linking permissions, please visit the RAND permissions page (http://www.rand.org/publications/ permissions.html). Published 2012 by the RAND Corporation 1776 Main Street, P.O. Box 2138, Santa Monica, CA 90407-2138 1200 South Hayes Street, Arlington, VA 22202-5050 4570 Fifth Avenue, Suite 600, Pittsburgh, PA 15213-2665 RAND URL: http://www.rand.org To order RAND documents or to obtain additional information, contact Distribution Services: Telephone: (310) 451-7002; Fax: (310) 451-6915; Email: order@rand.org Cover photo courtesy of Thinkstock/iStockphoto. The research described in this report was supported by a contribution by Christopher D. Petitt, principal of Blue Haystack, a financial research and consulting firm, and by the RAND Center for Corporate Ethics and Governance. Library of Congress Control Number: 2012948078 ISBN 978-0-8330-7684-7 iii Preface Hedge funds are investment pools open to high-net-worth investors and institutions but not to the general public. In part because of this restriction, hedge funds have, until recently, been subject to reduced reporting and oversight regulations. ey have also been reluctant to provide even general information on their operations and strategies to the public, fearing that such information could be construed as making a public oering. e result has been very poor public understanding of hedge funds and their role in the nancial system. Like other participants in the nancial system, hedge funds invested in many of the nancial instruments linked to the nancial crisis of 2007–2008. As a consequence, their role in the nancial crisis and potential contribution to systemic risk have drawn increased atten- tion from Congress, regulators, participants in the nancial system, and researchers. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Pub. L.111-203), regulations are currently being developed that have the potential to signicantly aect the hedge fund industry and its role in the nancial system. To improve the general understanding of hedge funds, this report provides an overview of the hedge fund industry, of hedge fund strat- egies and operations, and of the role of hedge funds in the nancial system. To better understand how hedge funds might contribute to systemic risk, it investigates the role hedge funds played in the nancial crisis and revisits the consequences of a large hedge fund’s failure in the late 1990s. It also examines whether and how the ongoing nancial reforms address the potential systemic risks posed by hedge funds. iv Hedge Funds and Systemic Risk is research was supported by a contribution by ChristopherD. Petitt, principal of Blue Haystack, a nancial research and consulting rm. It was also supported by the RAND Center for Corporate Ethics and Governance. e report should be of interest to policymakers, reg- ulators, members of the nancial community, and others interested in improving the stability of the U.S. nancial system while maintaining its dynamism and eciency. The RAND Center for Corporate Ethics and Governance e RAND Center for Corporate Ethics and Governance is commit- ted to improving public understanding of corporate ethics, law, and governance and to identifying specic ways in which businesses can operate ethically, legally, and protably. e center’s work is supported by voluntary contributions from private-sector organizations and indi- viduals with interests in research on these topics. For more information on the RAND Center for Corporate Ethics and Governance, see http://lbr.rand.org/cceg or contact the director: Michael Greenberg Director, RAND Center for Corporate Ethics and Governance 4570 Fifth Avenue, Suite 600 Pittsburgh, PA 15213 412-683-2300 x4648 Michael_Greenberg@rand.org Questions or comments about the monograph should be sent to the project lead: Lloyd Dixon, Senior Economist RAND Corporation 1776 Main Street, P.O. Box 2138 Santa Monica, CA 90407-2138 310-393-0411 x7480 Lloyd_Dixon@rand.org v Contents Preface iii Figures ix Tables xi Summary xiii Acknowledgments xxvii Abbreviations xxix CHAPTER ONE Introduction 1 Potential Contribution of Hedge Funds to Systemic Risk 4 Research Methods 5 Organization of is Report 6 CHAPTER TWO Background on the Hedge Fund Industry 9 Overview of the Hedge Fund Industry 9 Legal Structure and Role in the Financial System 9 Number of Hedge Funds and Assets Under Management 12 Restrictions on Investor Withdrawals from Hedge Funds 15 Characteristics of Hedge Fund Investors 16 Distribution of Funds in the Industry, by Size and Characteristics of Hedge Fund Advisers 17 Hedge Fund Returns and Investment Strategies 21 Attributes of Hedge Funds at Amplify and Mitigate eir Potential Contribution to Systemic Risk 28 vi Hedge Funds and Systemic Risk CHAPTER THREE e Collapse of Long-Term Capital Management 31 Factors Leading to the Collapse of Long-Term Capital Management 31 e Rescue of Long-Term Capital Management 33 e Aftermath of the Collapse of Long-Term Capital Management 34 Lessons from the Collapse of Long-Term Capital Management 37 CHAPTER FOUR Hedge Funds and the Financial Crisis of 2007–2008 39 Factors Underlying the Financial Crisis 39 Hedge Fund Contribution to the Financial Crisis rough the Credit Channel 41 Impact of Hedge Fund Losses on Creditors 41 e Failure of the Bear Stearns Hedge Funds 43 Hedge Fund Contribution to the Financial Crisis rough the Market Channel 45 Hedge Fund Contribution to the Buildup of the Housing Bubble 45 Hedge Fund Deleveraging 50 Short Selling 55 Hedge Fund Runs on Investment Banks 59 Assessment of Hedge Fund Contributions to the Financial Crisis 61 CHAPTER FIVE Potential Hedge Fund reats to Financial Stability and Reforms to Address em 63 Potential Hedge Fund reats to Financial Stability 63 Lack of Information on Hedge Funds 63 Lack of Appropriate Margin in Derivatives Trades 64 Runs on Prime Brokers 64 Short Selling 65 Compromised Risk-Management Incentives 65 Lack of Portfolio Liquidity and Excessive Leverage 66 Financial Reforms at Address Hedge Fund Contributions to Systemic Risk 68 Reforms at Address Lack of Information on Hedge Funds 68 Contents vii Reforms at Address Lack of Appropriate Margin in Derivatives Trades 74 Reforms at Address Hedge Fund Runs on Prime Brokers 77 Reforms at Address Short Selling 79 Reforms at Address Risk-Management Incentives 82 Reforms at Address the Liquidity and Leverage of Hedge Fund Portfolios 86 Summary 96 CHAPTER SIX Conclusion 99 APPENDIX Regulatory Reforms at Address Potential Systemic Risks Posed by Hedge Funds 103 References 107 [...]... savings to the corporate sector and allocates investment funds among firms, it allows intertemporal smoothing of consumption by households and expenditures by firms, and it enables households and firms to share risks (Allen and Gale, 2001) 4 Hedge Funds and Systemic Risk systemic risks posed by hedge funds. 10 Although of potential regulatory concern, the issues raised by hedge funds for investor protection... the performance of hedge funds compares with that of other investment vehicles In the remainder of this introductory chapter, we review the pathways through which hedge funds may potentially contribute to systemic risk, the methods used in our analysis, and the organization of the report Potential Contribution of Hedge Funds to Systemic Risk Hedge funds can contribute to systemic risk through two main... awareness that hedge funds could be a source of risk to the financial system Hedge funds also invested heavily in many of the financial instruments at the heart of the financial crisis of 2007–2008, and it is appropriate to ask whether they contributed to the crisis This report explores the extent to which hedge funds create or contribute to systemic risk By systemic risk, we mean the risk of a major and rapid... explore the role hedge funds played in the financial crisis We also examine the consequences of the 1998 failure of LTCM, a large hedge fund In addition, we examine whether and how the recent financial-reform legislation, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, addresses the potential systemic risks posed by hedge funds xiii xiv Hedge Funds and Systemic Risk The analysis... prices and instability of the financial system.7 Finally, the lack of public information about their operations and reduced regulatory oversight has meant that hedge funds remain mysterious to many and are an easy target for blame when there is a financial collapse.8 This report explores the extent to which hedge funds create or contribute to systemic risk By systemic risk, we mean the risk of a major and. .. bias than in funds with a short bias Hedge funds can, in principle, contribute to systemic risk through a credit channel and a market channel Systemic risk can arise through the credit channel when hedge fund losses result in default to creditors and the financial institutions with which they do business and these losses go on to cause broader problems in the financial system Systemic risk through... compromised risk management incentives), although questions remain about the effectiveness and comprehensiveness of the xxvi Hedge Funds and Systemic Risk approach The concern least well addressed is the potential lack of portfolio liquidity and excessive leverage Looking forward, policymakers and regulators should carefully monitor hedge fund leverage and collect data on and monitor the liquidity of hedge. .. He was convicted of fraud, conspiracy, and violations of securities laws in May 2011 At one point, Galleon managed more than $7 billion in assets (Lattman and Ahmed, 2011) 2 Schapiro, 2009 1 2 Hedge Funds and Systemic Risk Generally speaking, hedge funds cannot market their services to the general public and must either solicit funds only from large institutions and wealthy investors or limit ownership... by hedge funds xviii Hedge Funds and Systemic Risk Hedge Fund Runs on Prime Brokers During 2008, hedge fund managers withdrew tens of billions of dollars in assets from prime brokers and their parent investment banks These withdrawals were essentially a run on the bank, analogous to bank runs by individual depositors during the Great Depression, and contributed to the financial crisis Even though hedge. .. there is little indication that hedge fund losses led 2 Data provided to the authors by eVestment|HFN 3 Data provided to the authors by eVestment|HFN xvi Hedge Funds and Systemic Risk to significant losses at prime brokers and other creditors.4 It appears that prime brokers and other hedge fund creditors required adequate margin and collateral to protect themselves against hedge fund losses Contributions . examines whether and how the ongoing nancial reforms address the potential systemic risks posed by hedge funds. iv Hedge Funds and Systemic Risk is research. Strategies 21 Attributes of Hedge Funds at Amplify and Mitigate eir Potential Contribution to Systemic Risk 28 vi Hedge Funds and Systemic Risk CHAPTER THREE e